One of the primary misconceptions about the 2007–08 financial crisis is that it resulted from, and has thus ended, a monotonic march of deregulation over the last three decades of the 20th century. It is not entirely clear, first, what deregulation in this context means. If meant to indicate a lack of regulation, it is completely inaccurate—the US financial sector is highly regulated by myriad federal and state agencies. If it refers to a rolling back of regulatory oversight, it is only partially true.

The question of financial regulation must be approached from two vantage points. First, how can we preserve the economic growth and innovation that have resulted from a dynamic financial system? Second, how do we reduce the risks associated with an increasingly complex financial system without thwarting its further development and the resulting benefits?

Certainly, the financial world has opened up: many more financial instruments exist today than did 30 years ago, as the loosening of some restrictions in the 1970s helped spark an explosion of financial innovation. Mutual funds, venture capital, 401(k) plans, junk bonds—these are only the most familiar aspects of this explosion. Yet those specific tools have not been the most significant part of the financial revolution. Much more important have been their consequences, particularly their role in financing new companies and democratizing finance. In the past three decades, the United States experienced a transformation from bureaucratic capitalism to entrepreneurial capitalism.

After crumbling in the 1970s, the economy revived in the 1980s and 1990s, enjoying strong productivity, rising incomes, low inflation, and only two mild recessions. Entrepreneurship was at the heart of this resurgence—the United States experienced an extraordinary increase in the number of high-growth companies, which have carried the country to the frontiers of innovation. The industrial behemoths that dominated the economy in the 1960s gave way to smaller, faster-growing, more innovative businesses.

Building a high-growth company requires two things: innovation and money. Most people are familiar with the former—the IT revolution has made it almost a quotidian concept in modern America. The latter, however, is where we return to the idea of financial deregulation.

The great economic theorist of entrepreneurship, Joseph Schumpeter, recognized that entrepreneurs needed finance no less than innovation to build the companies they brought into existence. This means not just money but also credit, since entrepreneurs, by definition, at first possess no goods or services they can sell at a profit. The road to entrepreneurial success begins, then, with the extension of credit; this, in turn, requires the existence of credit sources. As it turns out, the 1970s and 1980s saw the expansion of such sources, which helped to fuel the entrepreneurial boom in the United States. Changes to the Employee Retirement Income Security Act (ERISA), for example, allowed pension fund managers to invest in high-risk assets, such as venture capital. The consequences of this change were remarkable: the amounts raised by venture capital firms grew to $1.3 billion in 1981, from $39 million in 1977. Much of this money financed young companies. Similarly, the incredible increase in junk bond financing helped both to finance start-ups and to restructure large companies. At the same time, the expansion of devices such as 401(k) plans led to the democratization of finance.

Regulation, moreover, is less straightforward in today’s transformed world of finance than is sometimes implied by simplistic calls for more regulation. Indeed, part of the reason we are facing such difficulty in resolving the credit crunch today is that the financial system, since the loosening of restrictions in the 1970s, has evolved into an enormously complex network. Physicist Albert-László Barabási, who has studied complex systems extensively, notes that they share an underlying network structure characterized by a large number of small nodes with only a few connections and a handful of nodes with many connections—the hubs.

American (and international) finance, as it developed over the past 25 years, is a prime example. In March 2008, the US Federal Reserve organized a rescue of Bear Stearns, one crucial reason being that Bear was a giant hub in an intricate web of financial transactions: it had 5,000 institutional counterparties to its credit default swaps, an astounding number. We can assume that its counterparties—Icelandic banks and Norwegian pension funds, among others—did not have such a large number of institutional partners. Bear was a hub, as was Lehman Brothers, whose collapse is widely seen as having precipitated weeks of panic throughout the financial world. An even larger hub was American International Group (AIG), whose pending failure was sufficiently frightening to inspire a government rescue.

How then is government to regulate in the face of complex networks? That is a much more freighted question than simply asking how much regulation we should have. The proper question now is, how can the government design rules and oversight mechanisms that make the complex financial network less vulnerable to cascading failure? We should not seek to prevent the network’s evolution.

Any expansion of the government’s purview, moreover, must be put in the right context. The modern era of economic growth—meaning sustained increases in per capita income and living standards—during the past 200 years coincides with a growing (or, in many cases, a not-shrinking) government. Is the federal government in the United States any less intrusive today than it was in 1800 or 1900 or 1950? Clearly not. The increasing frequency and extent of the federal government’s financial interventions form only a piece of a larger picture: constitutional-law scholar Jack Balkin has observed that President Barack Obama enters office as the most powerful chief executive in US history in nearly every dimension. Balkin referred specifically to the aggrandizement of the executive branch in national security over the past 8 years (really, the past 60). But when this aggrandizement is combined with the recent financial interventions, a picture of a government with power and authority almost beyond belief emerges. It would be quite easy for one to sit back and come up with banal prognostications about how this will reverberate in American life, and, undoubtedly, many will attempt to do that. None of us, however, will be the wiser for it.

The truth is, no one can predict the impact of these developments in the future. We can trace a clear trajectory of increasing government size and scope back many decades. If we plucked average US citizens from 1928 and transported them to the present, they might well be astonished at the change in the government’s role. When considering the size and scope of government, one thing we can be quite sure about is the much more salient issue of power, which, once granted, is not lightly relinquished—particularly when the grant of power is legitimate, as it (usually) is in the United States. We don’t speak of the Treasury Department as “seizing” authority for the Troubled Asset Relief Program (TARP) or of the Federal Reserve as illicitly expanding its oversight role. Yet power is power, and often the only limiting factor is what economist John Kenneth Galbraith called “countervailing” power: institutional structures designed to short-circuit its aggrandizement and abuse.

Unfortunately, in our rush to act boldly in the face of recession—a rush motivated, to be sure, by good intentions and the desire to avoid a depression—we seem to have forgotten this lesson of history.

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